Climate Change: Implications for Monetary Policy

The Reserve Bank of India’s (RBI) Monetary Policy Report released in April 2024 highlighted that climate change poses a serious challenge to the efficacy of monetary policy. It can slow economic growth, increase credit risk premiums, heighten inflation volatility and destabilise financial asset prices.

Climate-induced extreme weather events (e.g., storms, floods, droughts) can impair a bank’s credit portfolio and constrain credit flow, thereby stifling economic growth and increasing credit risk. A sudden increase in systemic credit risk in the financial system can increase credit risk premiums abruptly, thereby negating the policy aiming to reduce interest rates to grow the economy.

The primary goal of monetary policy is to control inflation but balance the same with adequate liquidity in the financial system. This will become increasingly challenging as climate-induced extreme weather events could lead to supply shocks beyond monetary policy’s control. There will be a trade-off between stabilising inflation and pushing for economic growth and financial stability. Climate-induced weather events can force productive resources to support climate adaptation measures and increase precautionary saving, which means lower investment. All these can increase nominal interest rates, nullifying the monetary policy targeting lower interest rates to grow the economy.

Incorporating climate risks into monetary policy

Given the above context, there is a clear case for central banks incorporating climate change in monetary policy formulations. This can support the policy’s primary objectives of delivering price stability, economic growth and financial stability. Monetary policy can also play a supportive role in mitigating climate change and enabling public finance for adaptation and resilience investments in addressing the adverse effects of climate change, manifesting as sudden shocks on the financial system.

Research papers published in the International Review of Financial Analysis and Bank for International Settlement (BIS) show that the risk premium related to the carbon intensity of loans is insignificant. Substantial investments in green technologies and climate adaptation require a more targeted and proactive approach. Higher investment in clean energy and energy efficiency can reduce inflation volatility as the energy source will move away from the volatile prices of fossil fuels and increase India’s energy security. Reducing reliance on imported fossil fuels can help the RBI manage exchange rates better.

How can monetary policy tools help in meeting India’s climate finance targets?

The existing set of monetary policy instruments deployed by financial regulators are neither designed for managing climate risks nor do they help increase climate finance in India.

The technique of selective credit control is one monetary policy tool to alter the volume of credit flows and the cost of credit to different sectors. The RBI can use the tool selectively to increase climate finance and enable a low-carbon transition for the Indian economy. It can increase the credit cost of carbon-intensive businesses and lower it for low-carbon businesses. For example, investment in climate-resilient crops can reduce the risk of hyperinflation of food prices during drought or flood events, which are likely to be more frequent and intense. These measures differentiate interest rates to offer lower rates to climate-resilient projects that can control inflation, particularly food prices. Central banks in Japan, Malaysia, and Thailand use selective credit control to support green projects by offering subsidised loans or targeted refinancing lines.

Notably, low-carbon technologies are more capital-intensive and sensitive to interest rates than carbon-intensive businesses. Central banks can design their monetary policy to push for low interest rates for low-carbon technologies. Further, monetary policy can also direct credit to green investments by tilting the playing field with differential pricing for borrowers supported by green collaterals.

We suggest some means through which central banks can decrease the cost of credit and drive more capital flow to green sectors within the existing monetary policy instruments.

Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR): Monetary policy can differentiate credit costs between carbon-intensive and green projects through these reserve requirements. It can increase CRR and SLR requirements for carbon-intensive projects to decrease high-carbon lending capacity while reducing the reserve ratio for green investments, thereby increasing credit flows towards green projects. Bank Indonesia, the country’s central bank, considers climate change when determining reserve requirements for banks.

Repo Rate and reverse repo rate: As financed emission is expected to be mainstreamed in the banking sector in the near future, the RBI can determine the repo rate, reverse repo, and bank rate based on the financed emission intensity of regulated entities. For example, the People’s Bank of China (PBoC) pays a higher interest rate to banks on required reserves with a better green credit portfolio.

Open Market Operations: As sovereign green bonds have already been introduced, the RBI can incentivise sovereign green bonds compared to conventional green bonds. Commercial banks holding more sovereign green bonds can be incentivised - RBI can pay them higher interest rates in open market operations. Excess SLR invested by commercial banks could be directed to sovereign green bonds.

Selective credit control and moral suasion are the two monetary policy tools through which the RBI can drive funding for green projects. The central bank can reduce the margin money requirements of green projects while increasing the same for carbon-intensive projects. Since the RBI joined the Network for Greening the Financial System (NGFS), it has been using more moral suasion, or nudging commercial banks, to accelerate capital flows towards green sectors while striving to mitigate climate-related financial risk. The RBI can use moral suasion more often and vigorously to spread awareness of climate-related risks while encouraging capital flows towards green projects.

Views are personal and do not represent that of the authors’ employers.

This article was first published in The Hindu BusinessLine.